Friday, November 07, 2008

Credit

I've been sitting on this post for a long time - mainly because I'm not a finance-world native (or inhabitant). But too little has been said about the importance of credit rating agencies.

A few months ago, a very left-leaning journalist friend of mine asked me to listen to a This American Life show entitled The Giant Pool of Money. It's a great show that tries to get at some of the characters in this drama - from a borrower, to a lender and reseller, and so on up the chain. As always - they portrayed some great characters.

But whereas Ben listened to that show and felt nothing but contempt for the bankers who made their millions (and were now worried about living their lifestyle on less that $20K per month), I came away with a slightly different take. Yes - that banker was a douche with his I-chill-with-B-list-celebrities lifestyle, but really, everyone in the chain was just making the best of their situation.

That chain of people existed all over the world. The borrower was smart for recognizing that he/she could get a massive loan with no money down - a risk-free proposition that was too good to be true. The lender realized that he could make great commissions, and sell even the sketchiest of loans. The people 'securitizing' large portfolios of loans also knew that they could get away with what they were doing, and kept purchasing below-par loans, and getting them rated highly. And the credit-rating agencies were getting paid lots of money to give these portfolios good ratings, so they kept at it.

So what am I saying? Is no one to 'blame'?

What annoys me that people still make references to the credit worthiness of certain companies, bonds, or whatever - based on those same credit ratings. Remember - those credit ratings that were given under such a conflict of interest.

The credit-rating agencies were the ones that provided lubricant for the entire rest of the chain. If it weren't for their excellent ratings, investors worldwide would never have put their pension funds in securities which consisted of underperforming loans bought from a knowing and incredulous lender who loaned a boatload of money to any warm body that wanted it.

There are many reasons why I'm unhappy about the bailout. But relevant to the discussion above is the fact that investors who wrongly trusted the credit ratings never got burnt. And so they, and we the public, continue to put our trust in them. As if Moody's improving or dropping the rating of a particular bond should hold any water. The bailout short-circuited the natural feedback mechanism that would have resulted in investors deciding that credit-rating agencies needed more transparency if they were to be trusted, and that investors would need to do a significant amount of their own due diligence before making an investment (and not just relying on a 3 letter rating).

What else was bad about the bailout? No one really gave a thorough explanation of what would happen if there was no bailout. The so called experts just shook their heads, wagged their fingers and said that things would be "so bad, that it was beyond comprehension".

Really? Isn't it interesting that these 'experts' were the ones who stood to gain the most from a bailout (the community of bankers, not necessarily specific people)? And isn't it interesting that these great proponents of free markets suddenly decided that free markets would not be able to solve this situation?

I'm not arguing against a bailout. I honestly don't know enough to know that it wasn't required. But I do know for sure that the public was hoodwinked yet again. There was a crisis, a rhetoric of fear, a waving of hands, and presto - the enormous financial risk that should have been borne proportionally by the people who made investments was suddenly spread thinly across the American people.

And so, we continue to fight for low interest rates, which can only be sustained by the enormous amounts of cash that the American public has put up. We taxpayers are effectively lending money at well below the fair cost of capital. What do I mean by that?

If there was no bailout, it's not possible that money would not be available. Money would be available. It would just be available at ridiculously high interest rates. There are enough people in this country who are sitting on several hundreds of millions of dollars; who'd be willing to lend it out for 20 - 30 - 40% interest. And maybe that reflects the true risk of lending money in today's environment. So why are taxpayers shoring up the money to lend to banks at rates significantly lower than that? It doesn't make sense.

It's just unfortunate that the wool has been pulled over our eyes yet again. Once when this country rushed to fight a war in a country that had nothing to do with the terrorist threats that it was supposedly reacting to. And again this year, when we mortgaged our futures so that the financial world could try to maintain its status quo.

2 comments:

It is not just the bankers who will suffer the high cost of money and the depletion of savings invested in stocks, it will be the vast majority of the American public. This is the real danger of modern economies. The instruments of trade, the stock prices, the financial papers, are dependent for their value on the economic health of the financial institutions and the money supply.

And nowhere is saving invested more in equity and bonds than in the US. That is the cost of progress.

In this age, nobody gives a hoot about commodities (for which no credit rating is needed), except Jim Rogers and some others perhaps. Derivatives and stocks is where the average Joe parks his money.

Most US savings, including pension funds, are invested in equity. It is impossible for a democratic government to refuse to respond to a situation in which a majority of its taxpayers are going to lose their life's savings.

Suppose the large banks, insurance companies like AIG, the Dow firms equity prices, go bust in America (as they, except Dow, already are in a danger of). What do you think will happen? In the worst (but not improbable) case?

I agree with you for the most part - except that I'm not convinced that the bailout will avert the impending disaster.

Also, since you brought up the improbable case, 'no jobs, no money' != 'no future'. :) It just means that society goes through a reboot/realign process whereby things are reorganized according to the new realities.

So if cost of capital is very high, it no longer will be considered "financially irresponsible" for GE to sit on cash reserves and NOT use commercial paper for payroll - rather, that sort of thing becomes the prudent decision.